SPIEGEL ONLINE

11/22/2010 11:30 AM

Europe's Neverending Crisis

Can the Euro Still Be Saved?

The countries of the euro zone are hopelessly divided over the question of how to save the currency in the long term. Bailouts for individual countries like Ireland and Greece can only be a temporary solution. Meanwhile, an internal paper drawn up by the German government has revealed Berlin's plans for forcing private-sector investors to take their share of losses in future crises. By SPIEGEL Staff

In the time since European leaders named the Belgian politician Herman Van Rompuy president of the European Council a year ago, the public has taken little notice of the reserved native of Belgium's Flanders region. But that changed last Tuesday, when Van Rompuy made headlines across Europe with a brief remark.

"We all have to work together in order to survive with the euro zone, because if we don't survive with the euro zone we will not survive with the European Union," Van Rompuy said during a panel discussion. With his comments, he expressed what many people in Brussels had been thinking but few had dared to say out loud.

As it happens, Van Rompuy would also have preferred not to say what he said. Two days later, he claimed that he had been misunderstood. He had apparently stuck his neck out too far. But that doesn't change the fact that the statement itself was correct.

Euro-zone governments have spent months trying to end the crisis facing their common currency, but the danger has not been averted. On the contrary, the crisis meetings have returned and billions in emergency funds are needed once again. And there is still no end in sight to the crisis.

Merely Temporary Relief

European leaders have tried all kinds of measures in the bid to save the euro. They approved a bailout program for Greece and a massive rescue fund for the entire euro zone, they whipped legislation through their parliaments and they expanded the articles of the Lisbon Treaty to their legal limits (and beyond, many would argue). The European Central Bank (ECB) has even violated an ironclad taboo by
buying up the bonds of ailing countries in an attempt to stabilize their prices.

But those steps only brought temporary relief, which only lasted until the next piece of bad news emerged. Yesterday it was Greece, and now it's the sorry state of Irish banks that poses a threat to the common currency. Each new report fuels the suspicion that the problems may be so pervasive that they can no longer be solved with conventional methods and by taking on more and more debt. Fears are growing that the crisis could lead to the default of individual countries or possibly even the collapse of the euro zone.

A deep divide between two almost irreconcilable camps runs through Europe. German Chancellor Angela Merkel heads one camp, consisting of the northern European countries. Merkel sees herself as the defender of a culture of stability of the sort that Germany has maintained since the days of the deutschmark. Her goal is to prevent the monetary union from becoming a kind of transfer union, with Germany as paymaster.

The second camp consists of the so-called PIIGS states, which have accumulated too much debt in the past and are now hoping for help: Portugal, Italy, Ireland, Greece and Spain. They want the thing that Merkel wants to prevent: a union in which the strong pay for the weak. Europe's institutions are now maneuvering between these two camps.

Causing a Stir

The first act of the current crisis began in the chic French beach resort of Deauville in mid-October. To the consternation of their allies, Merkel and French President Nicolas Sarkozy
announced the end of their ambitious goal to enforce a stricter stability pact with automatic sanctions for nations that break the deficit rules. In return, Sarkozy supported the German idea to assign some of the liability for future financial crises to private-sector creditors like banks and to accept the possibility of bankruptcy for an insolvent country. The 27 heads of state and government approved the deal at the
European summit in late October.

The plans, and the horror stories about Irish banks, caused a stir in the financial markets, pushing up risk premiums for the government bonds of all the ailing countries. "Merkel and Sarkozy apparently didn't think about the second act," comments Luxembourg Foreign Minister Jean Asselborn.

The yields on Irish government bonds rose as high as 8.6 percent at times -- 6.2 percentage points higher than the rate Germany pays to borrow money. This prompted Irish Prime Minister Brian Cowen to angrily note that Merkel's actions were "not helpful."

The German plan to automatically force bondholders to pay up when financial aid packages are approved "might seem attractive from a theoretical point of view," says ECB executive board member Lorenzo Bini Smaghi, but it would "in practice destabilize markets and have severe effects on economies in the euro area." It could ultimately achieve the opposite of what was intended, says the central banker, because "speculators would take advantage of the situation, while many small investors would suffer losses."

Responding to the accusation that it triggered the Ireland crisis, the government in Berlin said that the German proposal to involve private-sector investors has no effect on current market behavior because it focuses on the period after 2013. It insists that even government bonds purchased today would remain unaffected by any new rules. "In fact, this has nothing at all to do with the current debate over Ireland," says German Finance Minister Wolfgang Schäuble.

Misjudging Reactions

None of this has reassured the players in the financial markets. Once again, the German government was confronted with the realization that it cannot take action relating to the euro crisis without taking the reactions of investors into account. It misjudged this reaction once before, when it opposed financial aid for Greece for so long. In those weeks of uncertainty, the risk premiums for Greek government bonds continued to rise, while speculators began setting their sights on the bonds of the other PIIGS countries.

In the end, the euro-zone countries approved a comprehensive bailout package, leaving Chancellor Merkel in a losing position -- and looking like she was to blame. Her many adversaries in Europe argued that by taking such an uncooperative approach, Merkel made the crisis worse and drove up the costs of the bailout. The chancellor justified her actions by arguing that if it hadn't been for her tough stance, the Greeks would not have agreed to a strict austerity program and the involvement of the International Monetary Fund (IMF).

Merkel's reputation in Europe has been battered since then. Many see her as a betrayer of European ideals who stubbornly pursues German national interests. These critics feel vindicated by recent developments.

There is a rising tide of anger directed at the chancellor. Greek Prime Minister George Papandreou has criticized Merkel, saying that her reform plans could break the backbone of entire countries, while the Portuguese finance minister likens her plans to a foul in the game of soccer.

Wait-and-See Approach

All this criticism prompted the Germans to avoid taking a leading role in the current crisis talks in Brussels. They took a wait-and-see approach, even when they were put under pressure, especially by Portugal and Spain. Both countries are afraid of being sucked into the Irish crisis.

Unlike the Greeks, who implored their fellow Europeans to come to their aid, the Irish needed more persuasion. They didn't want the Europeans' money, because they fear it could weaken their sovereignty. And they argued they didn't need it either, because they won't need to borrow money on capital markets until the middle of next year.

This is true in theory. Ireland's problems are not its government finances but the balance sheets of its banks. However, the two things are closely related, because the country issued a comprehensive government guarantee for its banks after the financial crisis -- without suspecting how big the problem could turn out to be.

There has been a quiet exodus of billions from Ireland in recent weeks. Most international investors were no longer willing to lend Irish banks as much as a cent. The Irish banks repaid 55 billion ($75 billion) to their international creditors, mainly German, French and British banks, because the corresponding bonds had matured. But those creditors took the money and fled from the country. Only government-owned banks were still willing to lend money.

By the end of October, the Central Bank of Ireland had extended "extraordinary liquidity assistance" in the amount of 20 billion without the Irish banks providing the corresponding collateral. Also by the end of October, Irish banks had borrowed 130 billion from the ECB, which is more than the Greek banks borrowed. ECB experts have been hard at work at the Irish Department of Finance since September.

Even though the government has already taken a considerable portion of their risks off their hands, Irish banks are still dragging around property loans valued at 200 billion, which have not yet been adequately written down. Even the reserves of the better financial institutions have been used up, and the entire Irish banking system is on the verge of collapse.

In internal talks early last week, ECB President Jean-Claude Trichet made a far-reaching proposal. To solve the problem once and for all, he said, both Ireland and Portugal, which is also in financial trouble, ought to be provided with sufficient funds. These ideas went over well, especially with smaller member states.

Multi-Billion Bailout for Ireland Announced

A delegation of representatives of the EU, the IMF and the ECB arrived in Dublin on Thursday of last week to investigate how big the Irish problem really is. At that time, the draft version of a bailout plan had already been written.

It included two options. Under the "minor solution," the euro-zone stabilization fund would only cover the acute new shortfalls of the Irish banks. Under this scenario, the rescue fund would have to provide about 45 billion-50 billion, according to estimates made before the experts arrived in Dublin. London market insiders even feared that the sum could be as high as 60 billion-80 billion.

Many experts in the EU and a few finance ministries recommended a "bigger solution," which would involve taking Ireland "completely off the market," at least for some time. Otherwise, the proponents of this solution argued, the problems could begin all over again in the spring, when the government of Prime Minister Cowen will have to obtain new money to extend expiring loans. That plan would however cost "about 100 billion," said one official, "maybe even a bit more."

The British also indicated they wanted to contribute to the rescue package for Ireland. They may not be part of the euro club, but they are "good neighbors," said a British government spokesman.

Then, on Sunday, the Irish government announced it had
officially asked the EU and IMF for help. Europe's finance ministers quickly agreed to the aid in a hastily convened telephone conference on Sunday evening. It is not yet clear exactly how big the bailout will be, but Prime Minister Cowen said it would be less that 100 billion.

On Monday, the British Chancellor George Osborne confirmed that Britain had also offered a bilateral loan to Ireland totaling around 7 billion pounds (8.2 billion or $11 billion). "Ireland is our very closest economic neighbor so I judged it to be in our national interest to be part of the international efforts to help the Irish," he told BBC radio.

Reserved Approach

The German government has taken a reserved approach to providing financial help for the euro-zone's troubled members. Chancellor Merkel is under particularly intense pressure. In addition to public opinion in Germany, she has to take the views of the judges on the constitutional court and the coalition parties' parliamentary groups into account. The Karlsruhe-based constitutional court is currently reviewing several constitutional complaints against the billions in aid for Greece and the establishment of the European stabilization fund, and the number of such complaints could soon rise.

"In the event that Ireland also applies for assistance from the EU stabilization fund, we will immediately file a motion for a temporary injunction with the constitutional court to prevent the funds from being disbursed," said Berlin legal scholar and economics professor Markus Kerber ahead of Sunday's announcement.

He is one of the appellants filing a suit against the EU stabilization fund in Karlsruhe. If billions are made available for highly indebted countries with financial difficulties, the monetary union will turn into a transfer union, Kerber argues. In addition, he says, the government's approval of the fund violates the property guarantee under Germany's constitution, which is known as the Basic Law. "Article 14 of the constitution guarantees a secure, stable currency," says Kerber.

Peter Gauweiler, a member of parliament for the conservative Christian Social Union (CSU), also has constitutional concerns about aid for Ireland, and he believes that the prospects of his suit against the EU rescue fund are improving. "If Ireland asks for help from the EU now, this will confirm the basic assumption of my constitutional complaint, namely that the basis for a secure euro in the Treaty of Maastricht has become obsolete," he said recently.

Criticism of Low Corporate Tax Rate

Politicians from the conservative Christian Democrats (CDU/CSU) and their coalition partner, the pro-business Free Democratic Party (FDP), are also closely watching each step the German government takes in Brussels. Markus Ferber, the chairman of the CSU group in the European Parliament, wants to tie aid for Ireland to strict conditions. "We also managed to obtain tax increases in the case of Greece. The same thing has to happen in Ireland," says Ferber. "It is unacceptable if a country relies on the solidarity of the community while continuing to secure competitive advantages over its benefactors through the use of tax dumping."

He is referring to Ireland's low tax policy. Corporations in Ireland pay a low corporate tax of 12.5 percent. "If they had our system, they would be swimming in money," says economist Hans-Werner Sinn, president of the Munich-based Ifo Institute for Economic Research.

The tax question had been the sticking point in the bailout negotiations. The tax question is non-negotiable, said the Irish government. Without concessions there will be no money, responded officials in Brussels.

Tense Situation

Nevertheless, it was clear that there would be a compromise in the end, and that Ireland would get help. It is hoped that the bailout will bring calm to the financial markets, at least for the time being. But what happens after that? Won't the markets' attention turn to Portugal next? Not even Portuguese Finance Minister Fernando Teixeira dos Santos is willing to rule out that his country could find itself in a situation in which it would need the protection of the rescue fund. His counterpart at the Foreign Ministry can even imagine Portugal being ejected from the euro zone.

The rescue fund was approved to calm the financial markets. Its mere existence was expected to reduce tensions to the point that no country would actually have to make use of it. Instead, the situation has become more and more tense for many countries in the interim.

The European Union and the IMF envisioned a fund comprising 750 billion to protect their weaker members. This money would be sufficient for Ireland and Portugal. But things would become more difficult if Spain needed help. This is a situation Europe's governments did not anticipate, who reasoned that what should not be allowed to happen could not happen.

Apparently they assumed that the problems would be largely resolved by the time the rescue fund expires in 2013. It was expected that by then the PIIGS countries would have cleaned up their finances and be able to borrow money at reasonable rates again. Now the European governments must face a different reality, coupled with the question of what happens in 2013.

Internal Government Document Outlines Planned Crisis Mechanism

Chancellor Merkel is determined to prevent the rescue fund, in its current form, from becoming a permanent solution. She envisions that the construct will be replaced with a "permanent crisis management mechanism" when it expires in 2013. A plan developed by the German Finance Ministry has already been coordinated with the Chancellery, the Foreign Ministry and the Economics Ministry. German Finance Minister Wolfgang Schäuble intends to present the plans in detail at the next meeting of the Euro Group and the council of finance ministers in Brussels in early December.

According to a "non-paper" drawn up by the Finance Ministry, "the crisis mechanism is designed to allow for a fair balancing of interests between the debtor country and bond creditors," so that "systemic effects" on financial markets and the monetary union are avoided. A non-paper is a document that is so confidential that it doesn't really exist.

Change in Payment Terms

According to the Germans' plans, the conditions for all new bonds in the euro zone would include a debt restructuring clause as of 2013. The goal of the clause is to "make it possible to achieve a legally binding change in the payment terms through majority decisions of the creditors in the event of the debtor's inability to perform." The document lists maturity data extensions, rate reductions and debt waivers as measures.

A neutral chief negotiator would mediate between bankrupt countries and investors. "This task should be assigned to an inter-governmental institution that can also be a provider of financing at the same time," the document reads.

The new facility could also provide ailing countries with liquidity assistance. The money for the program would come from two sources. First, there would be the revenue from the penalties euro-zone countries would pay for repeatedly violating the upper deficit limit. Second, the euro-zone countries would pay into the fund, with their contributions possibly being based on their shares in the ECB.

A condition for the procedure is an analysis of a country's "debt capacity" prepared by the European Commission, the ECB and the IMF. German government experts are convinced that their plan will be successful. "The affected country gets a realistic prospect of quickly regaining its reputation and trust," they write, while the creditors would receive the chance of "securing a portion of the value of their bond."

The drawback of the plan is that it cannot go into full force in 2013, because not enough bonds with restructuring clauses will be on the market right away. Recognizing this weakness, the government experts concede that there would be a transitional period. This would amount to a "period of six to eight years, for which transitional solutions will have to be found."

Euro Bonds Suggested

The document does not describe what this could look like. In bilateral talks, Schäuble is already seeking allies for the plan, such as his French counterpart Christine Lagarde. But many countries have completely different ideas. Luxembourg Prime Minister Jean-Claude Juncker supports the idea of issuing euro bonds. These are government bonds whose repayment is not guaranteed by the issuing country but by the entire monetary union.

The southern euro-zone countries think this is an excellent idea. The Germans and the Austrians are against it. This sort of project would penalize those "who are dutifully sorting out their national finances" and benefits those "who haven't done their homework," says Austrian Finance Minister Josef Pröll.

"When everyone is liable for everyone else, there is very little incentive for individual countries to keep their own house in order," warns Christoph Rieger, a bond expert at Germany's Commerzbank. This, says Rieger, jeopardizes the currency as a whole.

Indeed, all of the proposals to solve the euro crisis share the same problem: They have the potential to make things even worse.